Bracket creep is a stealthy and dishonest form of taxation

Dr Eric Crampton
Sunday Star Times
30 October, 2022

If you want to know the effects of small changes to tax rates or tax thresholds on government revenue, Treasury provides a handy calculator. But the calculator breaks if you ask it to tell you the effects of inflation on tax revenues since April 2021, when the new 39% tax rate came in.

It warns, “The change is too large for this model to give a realistic estimate of change in tax revenue.”

Parliament did not legislate for a tax increase large enough to break Treasury’s tax calculator.

Nobody proposed it. Nobody campaigned on it.

It never went to Select Committee for deliberation. No tax experts analysed the distributional consequences of it or its affordability.

It never received Royal Assent.

Parliament simply failed to undo that which Adrian Orr gifted it, at our expense.

Imagine if Parliament had increased taxes across the board when it introduced the 39% rate. The $14,000 threshold would be reduced to $13,000. The $48,000 threshold would drop to $44,000. The $70,000 threshold for the 33% rate would go down to $64,000. And the 39% rate would apply to incomes over $164,000 rather than $180,000.

Discussion about whether people earning $65,000 should face a 33% tax rate might have been heated.

Thanks to the Reserve Bank of New Zealand having forgotten about its one big job while pursuing other trendy objectives, $70,000 today is worth the same thing as $64,000 in April 2021.

Failing to inflation-adjust tax thresholds, since April 2021, pushed some 40,000 people from the 10.5% bracket into the 17.5% bracket, about 187,000 people from the 17.5% bracket into the 30% bracket, 161,000 people from the 30% bracket into the 33% rate, and about 18,000 people from the 33% rate into the new top 39% rate.

As consequence, the government collected about $1.3 billion extra in tax – though both the figures on the numbers of people and revenue effects come with a heavy caveat from Treasury. Changes this large cause changes in behaviour, and those behavioural shifts are not in Treasury’s simple model.

But it gets worse.

The only adjustment to New Zealand’s tax thresholds since October 2010 has been an additional 39% rate on income over $180,000. That came into effect in April 2021. But the value of money has changed.

Adjusting the tax bands back to those of October 2010 would have substantial effects. $48,000 in October 2010 is equivalent to about $63,000 today.

When inflation’s effects over a little more than a year are enough to break Treasury’s tax calculator, something has got to give. At this point the question shouldn’t be whether to adjust the tax bands for inflation, but how best to do it – and how to avoid this ever happening again.

Whatever your views on the appropriate size of government, a few basic principles should apply.

The government should not normally spend more than it is prepared to take in tax revenue. Careful accounting needs to be applied, so that long-lived infrastructure can be appropriately debt-financed and paid off by users over its lifetime. But operating revenue and operating expenditure should balance.

If a government wants to reduce the amount of tax it collects, it should reduce the amount it spends.

And if a government wants to increase the amount that it spends, it should have to explicitly legislate for the taxes needed to fund that spending – rather than let inflation do the work.

Together, those principles suggest a smaller immediate inflation adjustment if the government wants to spend more over time, and a larger one if the government is prepared to spend less. Government spending is now far in excess of what it was even in 2017, and much of the increase has nothing to do with Covid.

But either way, unless a government adopts a flat tax immune to bracket creep, the tax thresholds should automatically adjust afterward, every 1 April, whenever accumulated inflation warrants bumping a threshold up by $1,000.

Tax brackets could track CPI inflation, so after-tax earnings are protected. Or they could track positions in the income distribution where the tax thresholds hit. When Labour took office, you had to be in the top 21% of earners to touch the 33% tax rate. By the 2020/21 tax year, the top 32% of earners paid at least the 33% tax rate.

Either way, Parliament would have to be honest about how it gets its money. Bracket creep is a stealthy and dishonest form of taxation. Worse, it can easily lead to the impression that Parliament wants the Reserve Bank to ignore its remit and let inflation run hot.

Inflation indexing tax thresholds isn’t just good tax policy. When inflation is no longer a tidy little earner for central government, we might worry less about whether the Reserve Bank is really committed to fighting it.


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